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Monday, November 29, 2010

The debate over what Milton Friedman would say about QE2 can now be closed. Below is a Q&A with Milton Friedman following a speech he delivered in 2000. In this excerpted exchange with David Laidler, we learn that Friedman's prescription for Japan at that time is almost identical to what the Fed is doing now with QE2: (my bold below)

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So Milton Friedman said in 2000 that the Bank of Japan should do what the Federal Reserve would be doing 10 years later! In fact, if names, dates, and places were changed in the above excerpt one could get a 2010 Ben Bernanke Q&A. Friedman's belief that a zero policy interest rate could be contratctionary and thus required the central bank to buy long-term securities shows that he understood unconventional monetary policy long before it was vogue. He truly was a great economist.

Note, though, that his emphasis is still on expanding the monetary base as much as needed to start and maintain an economic expansion. This implies he saw an excess money demand problem in Japan, just as there is one today in the United States. He understood, though, the need to expand the monetary base through purchases of long-term securities rather than short-term ones. This is because short-term securities are close to a perfect substitute for the monetary base at a zero percent policy rate. Swapping perfect substitutes does not change anything in one's portfolio of assets and therefore has no effect on spending. Thus, Friedman saw the need for purchasing long-term securities, which are not perfect substitutes with the monetary base.

Although Milton Friedman probably would have preferred a rule-based approach to QE2, this excerpt is the smoking gun that ends all debate on whether he would have supported QE2. The case is closed.

Sunday, November 28, 2010

I made the case earlier that Miltion Friedman would have endorsed QE2 in some form. So what would F.A. Hayek say about QE2? Where would he stand on this issue? Larry White says he would not support QE2 , but he would have supported QE1:

But Lawrence White, an economist at George Mason University in Washington, DC, argues that this is an unfair characterisation. “Hayek was not a liquidationist,” he says, referring to the philosophy of Andrew Mellon, President Herbert Hoover’s Depression-era treasury secretary, who wanted to “purge the rottenness out of the system”. Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.

Yes, F.A. Hayek was a fan of stabilizing nominal spending, a point I have discussed before on this blog. The question that I don't know the answer to is whether he would have stabilized nominal spending around its existing trend level or some other value. If Hayek were stabilizing it around its existing trend level then he would be in favor of something like QE2. Presumably, though, he would have implemented it in a more rules-based form than the current ad-hoc design of QE2.

White believes, however, that Hayek would not have maintained nominal spending at its existing trend level. Okay, let's assume as a baseline case Hayek would have stabilized nominal spending at the point where it was before its collapse in 2008. If this were the case and if we looked to nominal spending per capita, I think one can make the case that Hayek might have been sympathetic to a rules-based version of QE2. Here is the reason: (Click on figure to enlarge)

This figure shows that domestic demand per capita is only at its 2007:Q2 value. Aggregate demand per capita shows the same thing: nominal spending per person has yet to reach its previous peak. So maybe Hayek would be sympathetic to further monetary stimulus. Again, there is no doubt he would have objected to the way QE2 is being implemented. I would love to know what type of nominal spending target he would have favored.

Many years ago a good friend invoked a boxing analogy in advising me on one of my many futile romantic pursuits. He told me that if in my pursuit of a certain woman I go down, I should go down swinging. Never look back with regret. I couldn't help but think of his advice when considering your pursuit of a more robust economic recovery via QE2. There is no romance in this case, but you do claim to be passionate about stimulating more economic activity via a monetary-induced surge in nominal spending. As you know, a key part to fulfilling this passionate pursuit of yours is to meaningfully raise inflation expectations (and by implication expected nominal spending). So are you giving it your all? Are you willing to go down swinging? The bond market says you ain't really trying: (Click on figure to enlarge.)

This figure shows average annual expected inflation over the next five years has been flatlining around 1.55% over most of November. For all the hopes and fears of QE2, this response is underwhelming. There is no passion in this figure! Time to change that. Come out swinging with an explicit nominal level target--preferably a nominal GDP level target--and a commitment to maintain it no matter the cost. Stand tall when blows from the political left and right try to undermine your efforts. Make the markets believe you are serious about shoring up nominal spending. Make them believe you will go down swinging if needed. Show them you are the man!

Lawrence Lindsey is concerned that QE2 might work as intended. He is afraid that if QE2 actually spurs an economic recovery there will be higher interest rates that, in turn, will create a fiscal crisis:

Now suppose quantitative easing is “successful” in the way the Fed intends, taking inflation close to the average 2.4 percent rate of the last two decades and government borrowing costs back to their two-decade average of 5.7 percent. To get an idea of what happens to the budget, assume this transition happens over three years, so that by 2013 interest rates are back to “normal.” This “return to normal” will mean the government’s interest costs will rise to $847 billion by 2015 and $1.15 trillion by 2019

[...]

Interest rates could also rise for a variety of other reasons. Much faster real economic growth could have the same effect. An additional point of real growth for five straight years would help by raising revenue by about $450 billion over five years, but a parallel increase in real rates would raise interest costs by $700 billion over the same period. The higher real rates and larger deficit would likely put a lid on the sustainability of any growth spurt

Lindsey is correct that an economic recovery will raise interest rates. In fact, rising yields will be a sure sign of economic recovery. His concerns, however, about a fiscal crisis seem rather misplaced on several fronts. First, it would be easier to deal with fiscal problems in a growing economy created by QE2 than in a Japan-style economic slump created by an aborted QE2. Second, keeping monetary policy tight by having no QE2 would create other problems that his analysis ignores, like further pressure for trade protectionism. Third, tight monetary policy would increase the likelihood of more fiscal deficits and fiscal problems. Consequently, I will cast my lot with QE2 and pass on the Lindsey prescription of tighter monetary policy.

Though much needed, QE2 it is far from perfect. One problem with QE2 is that it is being marketed as a monetary stimulus program that works by lowering long-term interest rates. Dropping long-term rates, the story goes, will in turn spur interest-sensitive spending and jump-start the economy. This marketing strategy seems wrongheaded to me because it (1) ignores other important channels through which monetary policy can work and (2) creates the wrong expectation that QE2 will only be successful if it maintains long-term interest rates at a low level.

The emphasis on the so called "interest rate" channel through which monetary policy actions are transmitted to the economy is pervasive in QE2 discussions. For example, here is Greg Ip explaining how QE2 works:

Under QE, the Fed shifts its focus to long-term rates from short-term rates, and buys as much debt as it needs to get long term rates down. If it ever gets long-term rates to where it wants, it will stop buying. If it thinks long-term rates have gone too low, it could sell...Monetary policy stimulates demand by lowering the real interest rate...

It is understandable that journalists would invoke this monetary transmission channel when explaining QE2 since Fed officials are doing the same. Here is this channel being endorsed by Ben Bernanke:

[A] means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities.Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.

This view is further reinforced in the FOMC minutes for the October 15 meeting. These minutes show that the FOMC considered targeting an long-term interest rate:

[P]articipants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce longer-term interest rates and thus provide additional stimulus to the economy.

This narrow emphasis on the interest rate channel ignores the fact that monetary policy can influence the economy through various transmission mechanisms. This New York Fed article, for example, notes that the transmission channels include the bank lending channel, the balance sheet channel, the wealth channel, the interest rate channel, the exchange rate channel, and the monetarist portfolio adjustment channel. I see the portfolio adjustment channel being much more important for QE2 than than interest rate channel for several reasons.

First, the portfolio channel acknowledges the reality that Fed purchases of government securities will affect the prices and yields of one's entire portfolio of assets, not just treasuries. This includes real money balances and the demand for them as an asset. Thus, it is through this channel that the real issue behind the weak U.S. economy can be addressed: the excess money demand problem. Ironically, Ben Bernanke acknowledged the importance of this channel at his Jackson Hole speech back in August, 2010. Unfortunately, his other speeches and Fed statements more generally create the impression QE2 is all about the interest rate channel.

Second, the interest rate channel works through a lowering of interest rates that stimulates interest-sensitive spending. This cannot be an important channel, however, if QE2 actually works. For if QE2 is successful in stimulating economy activity it must be the case that (1) expected inflation picked up at some point and (2) real interest rates picked up at some point in response to the recovery of the real economy. In other words, nominal interest rates--the sum of the real interest rate and expected inflation--will increase if QE2 is successful. This channel, then, will at best be fleeting.

That the interest rate channel will be fleeting if QE2 works is another reason why the narrow emphasis on this channel is wrongheaded: it creates the wrong expectation that QE2 will only work if long-term interest rates remain low. Thus, QE2 is bound to be plagued by second guessing and criticism from observers who only see monetary policy through the prism of the interest rate channel. For example, imagine there is a sustained rise in interest rates. I would view this as a sign that QE2 is working. Many observers, however, would probably view such a development as failure of QE2. I fear the Fed is setting itself up for trouble by framing QE2 as working solely through the interest rate channel.

Wednesday, November 24, 2010

A few weeks back, Paul Krugman made the case that surging commodity prices do not necessarily mean U.S. inflation is about to take off:

A bit more on commodity prices: among other things, all of those pointing to rising commodity prices as a sign of runaway U.S. inflation seem oddly oblivious to the fact that commodity prices are a global phenomenon, driven by world demand... recovery in the emerging world has led to a recovery in commodity prices, which had plunged in 2008. How much does all this have to do with Ben Bernanke, or U.S. policy in general? Not much.

The TIPS spreads over the next 5 years suggest roughly 1.7% annual inflation—slightly below the Fed target, even after the announcement of QE. Some point to the world gold market, but unlike TIPS spreads this doesn’t provide a point estimate of expected inflation in the US. Rather it reflects all sorts of factors such as expected new discoveries of gold, negative real interest rates, and gold acquisition by developing country central banks. Furthermore, gold prices have also risen sharply in yen terms; does anyone believe this is a forecast of high inflation in Japan?

The key point being made here is that commodity prices are influenced by many factors, not just U.S. monetary policy. Therefore, it would be difficult to draw any conclusions about expected inflation from them. I decided to do a quick check on these claims by looking at the relationship between the year-on-year percent change in commodity prices and the year-on-year percent change in industrial production for both emerging economies as whole and the United States for the period 2007:12 - 2010:8. The data comes from the IMF and the Netherlands Bureau for Economic Analysis. What I found is that the the emerging economy group rather than the Unite States was more closely associated with changes in commodity prices: (Click on figure to enlarge.)

These figures indicate that the wide swings in commodity prices over the last few years have more to do with the emerging economies than with the U.S. economy. The Federal Reserve, then, may not be as important a determinant of commodity prices as some observers believe. More importantly, there are no sure signs that the Federal Reserve is unleashing a massive inflation. If anything, the Fed is keeping inflation too tame.

The release of the GDP numbers this week got thinking about where nominal spending is on a per capita basis. Is it doing any better or worse than the below trend growth in aggregate nominal spending? To answer this question I took final sales to domestic purchasers and divided it by population to get domestic demand per capita. Here is what I found: (click on figure to enlarge.)

Unlike the aggregate version of domestic demand, this per capita version shows that domestic nominal spending has yet to return to its peak value.* It is now only at its 2007:Q2 value. In other words, nominal spending per person in the United States has been slower to recover than its aggregate counterpart. One explanation for the depressed spending levels is that there is still an excess money demand problem.

* If one looks at aggregate demand per capita (as measured by final sales of domestic produc divided by population), you get a similar result. However, it makes less sense to do aggregate demand per capita because it includes foreigners' spending on U.S. domestic product.

Wednesday, November 17, 2010

Over at FrumForum, Noah Kristula-Green gets some of the Open Letter to Ben Bernanke signers to discuss their motivations for doing so. One of the signers, Charles W. Calomiris, looks like he does not belong on that letter:

Charles W. Calomiris of the Columbia University Graduate School of Business told FrumForum in an email that he favored keeping interest rates were they currently were:

There are many reasonable alternative views on how to target monetary policy. I favor Ben McCallum’s proposal to target nominal GDP growth at about 5%. Since we were on track with that target before QE II, at least for the moment, I would neither be raising or lowering interest rates.

Though he also stated that he would be in favor of a looser monetary policy if the evidence could convince him the circumstances warranted it:

If there were evidence of a need for further loosening to raise the growth of nominal GDP to that target rate, then some quantitative easing might be a reasonable proposal.

If Calomiris believes in level targeting rather than growth rate targeting he definitely does not belong on that letter. Below is a figure showing the level of nominal GDP, its trend, and its forecast through the end of 2011. (Click on figure to enlarge.)

The gap between actual and trend nominal GDP in this figure is troubling, but more so is the fact that it is projected to grow over the next year. And yet folks are upset overQE2! Nominal GDP is nothing more than total current dollar spending. This is something the Fed can and should stabilize. That real problem with the Federal Reserve is not that its doing QE2, but that it is failed to stabilize nominal spending in the first place.

The dividend push comes as companies sit on an ever-growing pile of cash, with non-financial companies in the S&P 500 holding $1 trillion in cash or like assets at the end of the second quarter, according to Banc of America Securities LLC analyst Jeffrey Rosenberg. By one estimate, that cash level could rise to $2 trillion by the end of the year.

“Not only are we seeing a tremendous V-shaped recovery in corporate profits, but we are in fact seeing the biggest corporate profit recovery ever,” said Joseph A. LaVorgna, the chief United States economist at Deutsche Bank. “That means that the equity market is dirt cheap. That also means that companies have more money than they know what to do with.” Meanwhile,.... unemployment rate is still stuck at 9.6 percent.

Of course the best evidence for excess money demand is the sustained decline in the velocity of money:

A key objective of QE2 is to raise nominal spending. Given sticky prices and excess economic capacity, this increase in nominal spending would boost the real economy. Now the way QE2 can raise nominal spending is by raising inflation expectations. Higher inflation expectations creates the incentive for banks, firms, and households sitting on money to start spending it. In fact, the key problem facing the U.S. economy right now is an excess money demand problem. While it is true that rising inflation expectations may temporarily lower real interest rates too and thus stimulate interest sensitive spending, this effect is of second-order importance and is only temporary. The real and lasting reason rising inflation expectations are important is that they address the excess money demand problem.

Many observers miss this important point and its implications for interest rates. Imagine QE2 is successful in breaking the excess money demand problem and aggregate spending increases. The real economy starts recovering too. These developments would imply the following: (1) expected inflation must have picked up at some point and (2) real interest rates would start rising in response to the recovery of the real economy. In other words, one would expect to start seeing nominal interest rates--the sum of the real interest rate and expected inflation--to start increasing if QE2 is successful. QE2, then, would not only be a boon to the real economy, but also to savers and folks living on fixed income given the rise in real interest rates.

Now I think QE2 should have been implemented differently--the Fed should have announced an explicit rules-based nominal target and forcefully commit to maintaining it--and I am concerned that political pressure may prevent it from being effective. Still, if it does work in its current form then rising yields would be one sign of success. Though it is probably too soon judge its effectiveness based on this criteria, here is a look at the expected inflation and the real yield on 10-treasury securities. The figure covers the last month and half, the time period when Fed officials first started talking up QE2 up through the present. (Click on figure to enlarge.)

The blue line in the figure reveals that inflation expectations started increasing in October with the onset of the Fed's full court PR press on QE2. Inflation expectations had been downward trending all year until this point. QE2 reversed that trend. So on this point, QE2 appears to be working. (Inflation expectations, however, have not continued climbing since QE2 was made official and that is a little troubling.) The red line indicates that the real interest rate has seen a sudden spike in the past week. So on this point, QE2 appears to be working too. Again, I reach these conclusions with some trepidation since it is so early into the QE2 program.

I raise these points because some observers like the Wall Street Journal and Barrons are looking at the same data and making statements like the "Bond Market Defies the Fed" and "Bond Vigilantes Rise Again." They claim that the bond market is pushing back against the Fed and beating it. I say not so fast guys, the bond market may actually be following the QE2 according to plan. Let's wait and see how this plays out, but along the way don't forget that rising yields is actually a good sign.

Tuesday, November 16, 2010

Scott Sumner has written an open letter to conservatives. It is a response to the other letter written by conservatives to Ben Bernanke. He shows in it why they can support monetary stimulus. His letter has my endorsement.

By the way here is another post of his that has been put to animation:

Calling the Greg Mankiws and Ken Rogoffs of the Republican party: when will you get your own "open letter to Ben Bernanke" out? Are the other guys really the true representation of Republican economists? I hope not, but one cannot ignore the growing criticism of QE2 coming from conservative commentators. Ramesh Ponnuru of the National Review considers why this is happening:

Over the last month, with astonishing rapidity, opposition to looser monetary policy has become the default position of the Right. Sarah Palin, Paul Ryan, and Mike Pence have all condemned QE2. Conservative worthies have written an open letter to Ben Bernanke urging him to cease and desist. Conservative pundits who have never previously expressed any interest in monetary policy are now alarmed by the prospect of (as some of them put it) “hyperinflation.”

[...]

I suspect that intellectual inertia is affecting conservatives’ assessment of this issue as much as the merits. As in so many other areas of policy thinking, conservatives are still reacting to the experience of the late 1960s through the early 1980s–when monetary restraint was exactly what the economy needed. The last decade, in which excessively loose policy at least abetted a ruinous bubble, has reinforced the conservative preference for tight money. But that preference is not applicable at all times and in all circumstances, and it is no longer 1979.

Yet conservatives are talking about runaway inflation at a time when the consumer price index, which itself is generally considered to overestimate inflation, has been registering 1-2 percent inflation. The spread between inflation-indexed and unindexed bonds has also yielded a market prediction of inflation in that range. Opponents of QE2 say that the Fed should not be deliberately raising expectations of future inflation. Maybe they’re right. But let’s have some perspective. If the Fed delivers on the 2 percent average inflation it seems to want, we’ll still be below the average inflation rates of each of the last five decades.

I am having a hard time finding it when I look to inflation expectations. Here is the average annual expected inflation rate over the next five years implied the spread between nominal and real yields on treasury securities:

(Click on figure to enlarge.)

Note that most of the pick up in expected inflation occurs during October when Fed official were talking up QE2. Since then inflation expectations have not exploded but drifted around where they had been, around 1.6%. It is also worth noting in this figure that inflation expectations were steadily heading down for most of the year. QE2 has reversed that, but has yet to push inflation expectations up to the 2.0% value the Fed would like to see it. Contrary to the rhetoric, then, QE2 is not the great inflation creating machine some claim it is. And just to be clear, it is not inflation per se that the Fed or supporters of QE2 ultimately want. What they really want is to increase aggregate spending. Raising inflation expectations would do that as I explain here. If only the Fed would adopt a nominal GDP level target many of these problems woulddissappear.

Friday, November 12, 2010

Ramesh Ponnuru has a new article up at National Review titled Hard Money. Ponnuru considers the difficult question of what the Fed can do to avoid both deflationary and inflationary spirals while at the same time promoting macroeconomic stability. His conclusion is that the Fed should move to a NGDP level target. I am glad to see this idea get a hearing at the National Review. Take a look at this timely article.

Thursday, November 11, 2010

For those of us disappointed with the Fed's performance over the past decade, it is natural to wonder if the conduct of monetary policy will be better going forward. Well, if history is any guide then don't get your hopes up. That is the conclusion I draw from a new paper by George Selgin, William D. Lastrapes, and Lawrence H. White where they systematically explore the Fed's performance since its inception in 1913. Here is the abstract:

As the one-hundredth anniversary of the 1913 Federal Reserve Act approaches, we assess whether the nation's experiment with the Federal Reserve has been a success or a failure. Drawing on a wide range of recent empirical research, we find the following: (1) The Fed's full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed's establishment. (2) While the Fed's performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

In short, it is difficult to make the case that Fed has truly made a meaningful improvement in macroeconomic stability over its almost 100 years of existence. Sigh.

Wednesday, November 10, 2010

Though some folks would have you believe so. It is far from perfect--it needs an explicit nominal target to make it truly effective--but it is a step in the right direction. Martin Wolf agrees:

The sky is falling, scream the hysterics: the Federal Reserve is pouring forth dollars in such quantities that they will soon be worthless. Nothing could be further from the truth. As in Japan, the policy known as “quantitative easing” is far more likely to prove ineffective than lethal. It is a leaky hose, not a monetary Noah’s Flood.

[...]

The sky is not falling. But this does not mean the Fed’s policies are the best possible. It is probable that any impact on the yields on medium-term bonds will have a modest economic effect. It would be far better if the Fed could shift inflation expectations upwards, by issuing a commitment to offset a prolonged period of below-target inflation with one of above-target inflation.

In other words, Wolf believes QE2 may not pack a real economic punch in the absence of price level target. Michael Woodford, William Dudley, Charles Evans, and Paul Krugman agree with this assessment. I too am a fan of level targeting (versus growth rate targeting), but would prefer to see it done by targeting some measure of aggregate spending such as final sales of domestic product or nominal GDP. There are goodreasons to favor an aggregate spending level target over a price level target, but either approach would bring the nominal economy closer to its trend and in turn spur real economic growth. Unfortunately, though, the FOMC for some reason has chosen not to adopt a level target. This decision may amount to keeping the United Sates in economic purgatory. So, rather than worrying about QE2 ushering in the apocalypse worry about it being much ado about nothing.

Monday, November 8, 2010

Paul Krugman makes an important point in his NYT column: there is an excess money demand problem (my bold below):

For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little... The only way the Fed might accomplish more is by changing expectations — specifically, by leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash.

Yes, somewhere there are households and firms that are sitting on excess money balances. And understand these are not the debt-strapped households and firms that should be refraining from further spending. No, these are the households and firms that are creditors and thus the beneficiary of the debtors who are now saving more. Instead of spending their growing stock of money they are sitting on it because they see an uncertain economic future. Here is the rub: it doesn't have to be this way. If these creditor household and firms all simultaneously started spending their excess money balances this would increase aggregate spending and in turn spur the real economy.* Moreover, knowing that the real economy would improve going forward would feed back and reinforce current aggregate spending. A virtuous cycle would take hold and push the economy back toward full employment. But this not happening, there is still an excess money demand problem. No creditor household or firm wants to be the first mover and spend his/her money for a good reason: there is no guarantee anyone will follow. This amounts to a negative aggregate demand (AD) externality.

In order to fix this AD externality one needs an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously. Enter the Federal Reserve. It alone can change inflation expectations and thus motivate these creditors to start spending. Note that by changing inflation expectations the Fed is really changing expectations of future aggregate spending, the source of expected inflation. And by changing expectations of future aggregate spending it is changing the economic outlook for the better too. The Fed, then, is the one entity that can kick-start this virtuous aggregate spending cycle. However, in the absence of an explicit nominal target to shape inflation expectations it is not clear to me the Fed will be successful in fixing this aggregate demand externality.

*It is not always the case that an increase in total current dollar spending will shore up the real economy. But it is the case now because (1) there is resource slack and (2) there are sticky wages and prices.

So the debate over what Milton Friedman would say continues to be debated by policymakers and other monetary luminaries. This debate started with an Op-Ed I coauthored with Will Ruger in the Investor's Business Daily, received more attention from a similar article by David Wessel in the Wall Street Journal, and was further promoted by Terence Corcoran in the Financial Post. These articles upset the old school monetarists and apparently were discussed at a recent Karl Brunner conference where they were gathered. Next, Allan Meltzer published this Op-Ed in the Wall Street Journal where he argued Friedman would not support QE2. John Taylor chimed in that he agreed with Allan Meltzer's assessment. I replied that even by Allan Meltzer's criteria of what Milton Friedman stood for one could make the case that he would still support some form of QE2. And now the issue gets discussed by Ben Bernanke at the Jekyll Island conference.

Now I really don't want to spend any more time on this debate, but given that it has not died down let me add these few final remarks.

(1) I agree with Paul Krugman that ultimately we should make our decisions about monetary policy without appealing to authority. My original intent in publishing the Op-Ed was as a way to reach out to inflation hawks who claimed to be followers of Milton Friedman. I was hoping they would see Friedman's views were nuanced and that this would encourage them to take a more nuanced view. Ultimately, though, economic analysis should be based on facts and good macroeconomic theory, not an appeal to authority.

(2) With that said, the data do not lend themselves to the view that Friedman would necessarily be against QE2. As I show in this post, all measures of broad money growth are far from stable and are low. A properly executed QE2 could actually work to stabilizes these measures. Moreover, Friedman actually said a monetary policy that targeted the expected inflation rate was better than a money supply target. By that criteria there is no question he would support some kind of QE2.

(3) The only reason why Milton Friedman would be critical of QE2 is its ad-hoc nature. While Friedman would be for restoring monetary equilibrium, he would want it to be done in a predictable, rule-like manner. So far that has not happened. It is likely he would have argued the Fed should adopt an explicit nominal target and commit to doing whatever is necessary to maintain it rather than the make-it-up-as-we-go-along approach behind the QEs so far. The economy needs more certainty now and an explicit nominal target would help immensely on this front.

Update: I failed to mention that Scott Sumner talked about what Milton Friedman would do longbeforeIdid. In fact, my Op-Ed was motivated in part by his work on this topic.

I have notedseveraltimes now that our current economic problems are fundamentally the result of excess money demand. This understanding implies QE2 is ultimately about solving an excess money demand problem. Along these lines, Josh Hendrickson notes that the current excess money demand problem is unique because the Fed is paying interest on excess reserves:

With the Fed paying interest on reserves, open market operations literally entails the Fed exchanging debt for debt — specifically, Federal Reserve debt for Treasury debt... it should be clear that the Fed is not being expansionary when it exchanges debt for debt. Nonetheless, this is not the same thing as saying that the Fed cannot be expansionary.

Some commentators have assumed that the sole effect of quantitative easing is to reduce long-term interest rates and stimulate investment. This is wrong-headed and demonstrates... why obsessions with the interest rate effect are misguided. The point of quantitative easing is not to reduce the long-term interest rate, but rather to resolve monetary disequilibrium.

Suppose that there is an excess demand for money. Since money is the medium of exchange and is traded on all markets, this necessarily causes an excess supply of goods and services. The central bank can eliminate the excess demand for money by increasing the money supply. However, as has been discussed above, if the central bank is exchanging interest-bearing reserves for interest-bearing debt, it is essentially exchanging perfect substitutes. If this is the case, traditional open market operations will not resolve the excess demand for money. Rather, the central bank needs to exchange the interest-bearing reserves for something that is not a perfect substitute. Potential assets that satisfy this criteria could be anything from long-term bonds to a portfolio of stocks. The central bank purchases these assets in order to increase the money supply and resolved monetary disequilibrium.

Read the rest of Josh's post here. By the way, Josh just finished his Ph.D. and is on the job market. Give him a look.

Thursday, November 4, 2010

There has been plenty said about the FOMC decision to go ahead with QE2. Let me add that this plan could have packed a lot more punch if the Fed had committed to an an explicit nominal target. Instead we get several loosey-goosey references in the FOMC press release about Fed needing to keep inflation at a level consistent with its mandate. To be fair, Ben Bernanke does mention in his Op-Ed today that most members of the FOMC believe 2% is the inflation rate consistent with a healthy economy. Still, there would be a lot more certainty and wallop to the Fed's action if it would just come out and say "The FOMC is now committed to a X% nominal target and will do whatever is necessary to maintain it." Doing so would go a long way in shoring up and stabilizing inflation expectations. For some reason, though, the FOMC is afraid to make such an explicit commitment. Maybe it will still do so in the future. And maybe, just maybe it will really be bold and commit to a NGDP level target.

Wednesday, November 3, 2010

[Update: I see that Allan Meltzer has an Op-Ed in the WSJ where he argues Milton Friedman would not support Ben Bernanke's QE2. He is responding to those people who "believe the great Nobel laureate would favor this inflationary program. I am certain he would not." Meltzer's big counter argument is that "Friedman's main message for central banks was to maintain a monetary rule that kept the growth of the money supply constant." The problem with this claim is that it ignores Friedman's call for the Fed to target the expected inflation rate. As I show below, Friedman explicitly wrote this approach was better than targeting the money supply. But even if we ignore this point, Meltzer's key argument about monetary stability still does not imply Friedman would be against QEII. The growth rate of various money supply measures has fallen and are far from stable. If anything, QEII would move these monetary aggregates closer to a stable growth path. I would like to see how certain Allan Meltzer is after grappling with these two points, both of which are discussed in my post below.]

There are some observers who find the article Will Ruger and I did on Milton Friedman very irritating. They believe we have misrepresented his views. A key complaint they have is that our analysis ignores Friedman's long-standing commitment to stable growth in the money supply. Okay, let us look at the recent growth path of the money supply. Below is a graph showing the year-on-year growth rate of three monetary aggregates: M2, MZM, and M3. The M3 data comes Capital Economics. (Click on figure to enlarge.)

The growth rates of the monetary aggregates have been anything but stable. In fact, M3 and MZM--arguably better measures of money during this crisis than M2--have had a recent run of negative growth. While M2 has had positive growth, it too appears below trend. All of them have seen plunges in their growth rates. Would Milton Friedman really look at this graph and conclude there has been monetary stability?

With that said, one should note that in this 2003 WSJ article Milton Friedman appears to have moved beyond aiming to just stabilize the growth of the money supply. For in this piece he praises the Fed for adjusting M2 in response to a M2 "velocity bubble" in the 1990s. Friedman is endorsing the Fed's actions at this time to offset money demand shocks. Thus, in this article he is implicitly calling for the Fed to stabilize the MV part of the equation of exchange (i.e. MV=PY). So how does money velocity look right now? The graph below answers that question. It divides final sales of domestic product (a more accurate measure of AD than NGDP) by the monetary aggregates. (Click on figure to enlarge.)

Here again we see anything but stability. It is hard to believe that Friedman would not have been concerned by the pick up in money demand implied by this figure. Moreover, he would realize the that these figures together (i.e. %ΔM +%ΔV) indicate that the growth path of nominal income has not been stable either. This too would have concerned him.

Finally, it is worth repeating here that Friedman was supportive of the Fed adopting a target for expected inflation. He endorsed it in his book Money Mishief. The idea was originally Robert L. Hetzel's. In Hetzel's book The Monetary Policy of the Federal Reserve, he cites a letter Friedman wrote in 1991 where he says the following about this proposal (p. xiv):

It is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which... is always backward looking.

So Friedman endorses this approach by saying it trumps targeting the money supply. Now given that inflation expectations were headed down for most of the year (see here), it seems likely Friedman would be concerned on this front too. Only with the talk of QE2 in September did these expectations turn around. I suspect he would have been pleased.

Tuesday, November 2, 2010

Peter Boettke and friends take issue with the claim that Milton Friedman would support QEII. There is an interesting discussion there between the Austrians who take the excess money demand problem seriously and those Austrians who don't. Among other things, I learned from the comments that at a recent gathering of Monetarist luminaries the participants really disliked David Wessel's piece on Milton Friedman and by implication my piece too. In my defense I never have claimed to be a monetarist, only a quasi-monetarist.

Two recent articles speak to the advantages of a nominal GDP level target over a price level target. The first article is from The Economist which actually discusses a price level target but in so doing actually builds the case for a NGDP level target. The Economist article first describes the benefits of a price level target:

Assume that inflation of 2%, on average, is ideal. This implies that if the price level is 100 this year, it will be 102 next year and 104 (or more precisely, 104.04) in the second year. If inflation is only 1% in one year, a conventional inflation-targeting central bank would aim only to return inflation to a rate of 2% the next. This would leave the price level at 103, lower than its original implied path. In contrast, a central bank that targets the price level wants to make up any lost ground on prices. It would seek to raise inflation to 3% in the second year to get to a target of 104.

In theory price-level targeting is superior to inflation-targeting because it provides more certainty about the long-term purchasing power of money. Central banks always target inflation flexibly. The Bank of Canada and the Bank of England, for example, target a rate of 2% but permit a range of 1% to 3%. That means someone making a 30-year investment must plan for cumulative inflation of as much as 143% or as little as 35%. A credible price-level target eliminates that uncertainty.

So a price level target trumps an inflation target, but it has one glaring problem: it doesn't handle aggregate supply shocks very well. Here is The Economist:

There are questions, too, about how central bankers would deal with a one-time rise in the price level because of a new value-added tax, say, or higher oil prices. The boost to inflation would be temporary, but to the price level, permanent. In theory a central bank would have to wrestle all other prices lower no matter what the cost. It could make an exception, but too many exceptions would dent the bank’s credibility. Conversely, a positive shock such as lower oil prices or higher productivity that pushes prices lower would require the central bank to raise future inflation, driving down real interest rates and maybe risking an asset bubble.

Implicit to this discussion is that a price level target does great if the business cycle is dominated by aggregate demand (AD) shocks. But if aggregate supply(AS) shocks matter at all then a price level target can actually be destabilizing. Would we really want the Fed to tighten because a negative AS shock pushed up prices? This would require the Fed to further constrict an already weakened economy. On the other hand, if there were a productivity boom that implied a higher neutral interest rate and lower inflation rate, would we really want the Fed pushing interest rates below the neutral rate and raising AD above trend growth just to keep the price level stable?

What then is left? Ramesh Ponnuru provides an answer in a National Review article titled "Hard Money" (sorry, no link):

Economists Scott Sumner of Bentley University and David Beckworth of Texas State University are among those who have suggested that the Fed should move gradually toward a new, more rule-bound and predictable monetary policy. The first step would be to signal to the markets that the Fed is willing to do whatever it takes to reach 2 percent average inflation. Over time the Fed would move to stabilize and then slow the growth of nominal GDP, which is the size of the economy as measured in a given year’s dollars. If the nominal GDP target was for 3 percent growth and the economy grew by 2 percent, there would be 1 percent inflation.

That policy would bind the Fed to a rule, thus reducing the uncertainty that recent policy has generated, including the risk that we will get galloping inflation at some point in the future. But it is superior to simply targeting the inflation rate, Beckworth argues, because it incorporates two worthwhile types of flexibility. It allows the price level to move in response to supply shocks: An oil embargo would cause prices to rise, a technological advance would have the opposite effect. And it allows the money supply to move up and down in response to the demand for cash: In periods such as late 2008, when people were holding on to their money, the Fed would have loosened more than it did. But since the rule would have required tighter money during the boom years, the financial crisis might not have been as severe in the first place.

So the answer is a NGDP level target. There is some disagreement on exactly how fast NGDP should be growing and thus targeted. However, supporters of a NGDP level target agree that the beauty of a NGDP level target is that it forces Fed to focus on stabilizing AD while ignoring potentially misleading signals coming from changes in the price level. In short, such a rule would force the Fed to focus on a cause of the business cycles, not a symptom of it.

Terrence Corcoran weighs in on the discussion of what Milton Friedman would recommend if he were alive today:

A cottage industry is building around the question: What would Milton Friedman do? With the U.S. Federal Reserve on the brink of announcing a new round of quantitative easing to pump a fresh supply of money into the U.S. economy, people are looking around for economic guidance. Prof. Friedman, the Nobel-winning free-market economist who died in 2006, earned his Nobel on the basis of his monetary-policy work. He was a “monetarist” who promoted the idea that steady and stable increases in the money supply were needed to keep growth high and inflation low.

The consensus, more or less, appears to be that Prof. Friedman would endorse what Fed chairman Ben Bernanke is expected to announce tomorrow: another massive increase in bond purchases. If the Fed buys up to half a trillion dollars’ worth of bonds, pushing interest rates even lower, the theory is that such quantitative easing will drive Americans into doing something constructive with their money, activity that would push up money-supply measures.

Here is the piece that Will Ruger and I did on the topic and here is the article by David Wessel.

Monday, November 1, 2010

It seems to me that everyone fighting today over whether QEII will work are worried about whether the Fed can affect real rates, but are forgetting about the second step in the process. Once real rates rates fall, firms and households then have to be induced to borrow more, then consume or invest (I'm including the response to expected inflation in this). Even if we manage to change real rates, and I have never quarreled with the Fed's ability to do this (though the extent depends upon their ability to affect expectations), why do people think it will bring about a strong consumption and investment response in the current environment?...

Here is why I think QE will pack an economic punch, if done correctly. The expectation of permanently higher prices will cause cash-flushed firms, households, and other entities to start spending more today. Right now there is an excess money demand problem that could be stemmed by meaningfully changing the inflation outlook. Those folks and entities hoarding money would on the margin face an greater incentive to start spending given an significant increase in inflation expectations. (Yes, many households with weakened balance sheets are deleveraging and saving more. However, the rise in saving by these troubled households--by paying off debt, cutting back on spending, or buying other assets--should lead to more money for other non-troubled households unless the money is being hoarded somewhere else. Maybe the non-troubled households choose to sit on their money, maybe the creditors to whom the troubled households send their money are sitting on the money, or maybe it's the creditors' creditors that are sitting on the money. The details are not important, what is important is that somewhere in the economy there is an excess demand for money right now that is not being met by the Fed.)

Now assume the Fed does indeed address this excess money demand problem with QEII. Given sticky wages and prices, this pickup in spending (i.e. drop in money demand) will translate into real economic gains. This will encourage banks to start lending more as they see better credit risk going forward while the improved economic outlook encourages firms and households to start borrowing more too. On top of that, the higher expected inflation will drop the real interest rate and encourage more interest-sensitive spending. Next, we could consider how the pick up in asset prices might have a wealth effect on consumption. The pickup in asset prices could also improve troubled households balance sheets and thereby enhancing their access to credit. Finally, further depreciation of the dollar may spur exports. Bottom line is that there are multiple channels through which QE could work.

Paul Krugman replies to my post on QE in the Great Depression. He then notes that Gautti Eggertson corresponded with him on this discussion:

Gauti Eggertsson writes in to follow up on my piece on quantitative easing in the Great Depression. He points me to a 2008 paper (pdf) in which he shows that the coming of FDR, combined with America’s exit from the gold standard, was seen by markets as a huge regime change; it was, said FDR’s own budget director, “the end of Western civilization.”

This regime change immediately shifted expectations of future inflation, well before there was any actual surge in monetary base. That, rather than the quantitative easing per se, is how monetary policy — or more accurately, expectations of future monetary policy — gained some traction in the 30s liquidity trap. Again, an important lesson — but how relevant is it to current circumstances? Bernanke, unfortunately, cannot convince people that he’s bringing the end of Western civilization.

Two remarks. First, this is the point I was trying to make in my initial post: change inflation expectations and follow up with actual changes, as needed to support those expectations, in the monetary base.

Second, I don't understand Krugman's dismissal of this insight as relevant for today. There are many folks out there who do think Bernanke is bringing an end to an important feature of Western Civilization today: the value and importance of the dollar. In fact, Krugman himself admitted just last week he was shocked to see such beliefs. It gets worse, there are some who believe Bernanke's QE2 could usher in civil unstrife and maybe even a civil war. As noted by Ryan Avent, Karl Smith, and others, this Bernanke radicalism is already being reflected in the markets. Below is expected inflation rate from coming from the bond market. Note that after a nine-month fall it does a sudden turn around once the Fed starts talking up QE2 (Click on figure to enlarge):

What more does Krugman need to convince him that Fed is already shaping inflation expectations and can continue to do so if it plays its cards right? Again, have some faith in the efficacy of monetary policy.

This NY Time article highlights one of the key problems with the way the Fed currently functions (my bold below):

Everyone on Wall Street is waiting on the Fed. Whatever the outcome of Tuesday’s midterm elections, the Federal Reserve is widely expected to take new steps this week to spur the nation’s snail-paced recovery.. The question is how aggressively the Fed will act... Analysts expect the central bank to buy securities on the open market in an effort to the unlock the flow of credit to the economy. Estimates of the size of the program range from $500 billion to $2 trillion...

But while investors have been staking out their positions for weeks the announcement — and the potential ramifications — remain fraught with uncertainty. Given that the Fed’s news is expected to land as Wall Street is digesting Tuesday’s election results, analysts are bracing for a volatile day, particularly if the Fed underwhelms investors.

This shouldn't be. A modern central bank should have an explicit nominal target to help create certainty. Yet, here we are in the 21st century guessing what the most influential central bank in the world plans to do at its next meeting. In fact, we have been guessing all year as we watched in bewilderment as inflation expectations dropped from January through September. "Why wasn't the Fed responding?", we wondered. Then, suddenly, we learn in late September the Fed had had enough. Inflation would not be allowed to fall any further and this would happen with a second round of quantitative easing. Inflation expectations responded accordingly by jumping back up. I am glad for the change of heart, but enough of this monetary policy roller coaster ride! And this is not just any monetary policy roller coaster ride, but a Space Mountain monetary policy roller coaster ride where you can't see what is coming next. There are many issues with a gold standard, but at least one knew what to expect going forward. If we are going to make our fiat monetary system work we need to have the same forward-looking certainty. These past few years such certainty has been missing. It is not hard to imagine how much better our economy would have been had the Fed adopted an explicit nominal target a few years back. It is well past time for the Fed to move beyond its wishy-washy, guess-if-you-can policy goals and commit to an explicit nominal target.